As a D2C business, you probably have a firm understanding of your bestsellers and your slow burners, but do you know how much profit each individual product is generating? If the answer is no, it’s time to work out your contribution margin.
Contribution margin is the revenue left over from the sales of a product after you’ve paid for all variable expenses—we’re talking shipping costs and raw materials. The idea is that this leftover money (which usually gets turned into a percentage) goes toward your fixed expenses, like salaries, rent, and equipment. After these costs have been deducted, you can calculate your net profit.
While your profit margin (the total amount left over between sales and outgoings) tells you the overall financial health of your business, the contribution margin helps you understand how much each product is contributing to your profit. This means you can quickly see what products are working hard for you and which ones are gathering dust on your digital shelves.
How to Calculate Contribution Margin
To work out the contribution margin in monetary terms, simply subtract the variable costs per unit from the total sale price. For example, if a t-shirt retails at $10 and the variable costs of producing it are $4, the contribution margin is $6 ($10 - $4 = $6). The remaining $6 goes towards your fixed costs.
You can use the following formula to work out the contribution margin percentage (i.e. the percentage amount of each product’s revenue that goes towards your fixed costs):
Product variable costs/product revenue generated x 100 = contribution margin
So, if you generate $100,000 from product sales and your variable costs for making that product were $30,000, the contribution margin would be 30% ($30,000 / $100,000 = 0.3 * 100 = 30%).
Tip: Before you calculate your contribution margin, you’ll need to categorize your costs as fixed or variable. Fixed costs are expenses that stay the same each month regardless of how many products you produce. They include things like rent, salaries, and warehouse costs. Variable costs are expenses that change depending on the quantity of products you produce, such as raw materials, transportation fees, and utility costs.
This information will make it easier to determine what costs to subtract from the total sales revenue.
What is a Good Contribution Margin?
Obviously, the best contribution margin is 100%, but this is very rare if not impossible, especially in the ecommerce world. Of course, it’ll cost you something, even if it’s a nominal amount, to produce a product. With that being said, the closer you can get to 100%, the better. As a general rule though, anything above 50% is considered a good contribution margin.
If yours is below that, don’t worry—we’ve got some tips below for boosting your contribution margin across your entire product range.
How Companies Use Contribution Margin
Peel’s President & CRO, Ben Hindman recently got to sit down with the President of True Classic, Ben Yahalom for an in-depth Q&A around contribution margin. Peel and True Classic announced a partnership, which you can read about here.
The conversation was amazingly insightful, covering everything from how companies use contribution margin to direct advice and tips for maximizing contribution margin and finding contribution profit, regardless of your business size or growth stage.
Here are some highlights of the Bens chopping it up on the subject:
Ben H: Ben, what is a big question you’re asking about your Contribution Margin?
Ben Y: As simple as it sounds, I always ask, “What is it?” And I’m trying to understand what is the contribution profit per customer, more importantly than the margin percent, because that’s the proxy for LTV (lifetime value). We would then break it apart and try to understand the cumulative contribution profit per customer, by channel, by product category, by market, so we can basically drive it up and to the right and make the business more profitable.
Ben H: You have to unpack this for me; can you explain why you’re trying to break those things apart?
Ben Y: Of course. So, the northstar for our business on the marketing front is to maximize the customer base, and by that we look at the total active customers in that base; people who purchased from us over the past 6 months. And then separately to maximize the contribution profit per customer, which is essentially the LTV over different periods of time.
If I were to think about the scorecard for the company it’s that one chart of cumulative contribution profit per customer over time and our goal as a collective is to take that chart, bend it and raise it over time.
And so in order to do that, you need to start breaking it apart into its core components. What is making this chart? It’s different customers, who generate different orders, who purchase different products, who come from different markets, international vs US, who shop on different channels, right? So you have to start breaking that all down into the core components to understand what’s driving that LTV or cumulative contribution profit per customer; and more importantly, how can I get more of that and continue to drive that up?
Ben H: And what are the factors or dimensions that are driving contribution margin?
Ben Y: So, if you think about the definition, we take everything out of net revenue and go all the way down to contribution profit, so things like the product COGS, the payment processing fees, the shipping costs, the pick-and-pack for fulfillment, the marketing obviously which is a big expense, and we basically take expected returns, expected exchanges, CX tickets, there’s so many different components; and we just try to break it apart and understand, when it’s all said and done, what are we actually generating per customer in terms of contribution profit that flows down to the bottom line?
Ben H: Ben, at what stage in your business development did you start asking big questions about your contribution margin?
Ben Y: I would say it was our mentality since day 1. We bootstrapped this brand, so we had no other option other than to grow it profitably. So when you’re super focused on profit because you don’t have any other method to generate cash and continue to grow and reinvest the profit into the business, then you have to start being laser focused on that. I would say that this is one of the most important lines on the P&L. And for businesses who are in hyper growth mode, they need to understand how their activities maximize the contribution profit, not revenue and not any other metric in between.
We’ll be publishing the full video version of the chat on our socials soon. Follow us on LinkedIn for more updates!
5 Tips for Improving Contribution Margin
Whether your contribution margin is 30% or 80%, there’s always room for improvement (unless, of course, you're sitting at a very comfortable but near-impossible 100%). Here are a handful of activities you can do to boost your contribution margin.
1. Reduce Variable Costs
Scout around for cheaper suppliers for raw materials and compare the prices of different transportation companies. You might find a cheaper, better option that will automatically reduce your variable costs. It’s all about constantly assessing here and negotiating for better prices to reduce your overall costs.
2. Increase Your Prices
If you can’t find anywhere to cut your variable costs, you can always increase your prices to give your contribution margin a little boost. Be mindful of staying competitive, but don’t be afraid of bumping up your prices to see how it impacts your bottom line. Testing is key here. You don’t want to put yourself in a price range that drives your customers to competitors, or alienates your core base of loyal customers. Use your marketing to elevate the product to match the story with the price increase.
3. Purchase Additional Equipment
If you use specific equipment to produce your products, it can be worth investing in additional machinery to produce the same number of products in a smaller time frame. The initial outlay might be costly, but it can dramatically increase your contribution margins in the long term.
4. Practice Sustainability
Use lower-priced packaging materials and turn off your machinery overnight to save electricity costs. These might seem like obvious moves, but every little move you make helps when it comes to improving your contribution margin—even the smallest reduction in your variable costs can make a big difference over time.
5. Process Costing
Process costing is the method of tracking the cost of every step in the production process. Drilling down into each stage will help you identify places for improvement or where you can cut costs altogether.
Contribution Margin FAQ
What does contribution margin mean?
Contribution margin is a metric used to quantify how much sales revenue from each individual product goes towards your fixed costs after you’ve accounted for variable costs. It shows you how much profit you’re generating at a product level.
How do you calculate the contribution margin?
To calculate your contribution margin, subtract your total variable costs of a product from its total sales revenue. You can then work out a percentage by dividing what’s left after the variable costs by the total sales revenue and multiplying the decimal figure by 100.
Is it better to have a high or low contribution margin?
The higher your contribution margin is, the better. The ideal margin is 100%, but that’s impossible for D2C brands who tend to have to pay something to produce each product.
Your Contribution Margin Provides Product-Level Insights
It’s important to know your overall profit, but that doesn’t tell you a lot about what products are contributing the most. If you want to know how much each product is putting towards your fixed costs, you need to calculate your contribution margin and identify ways you can improve it by reducing your variable costs, increasing your prices, and investing in additional machinery and equipment.
If you want to start drilling down into your product performance and customer purchasing patterns to work on improving your contribution margin, you can try Peel free for 7 days to analyze all your post purchase data in one place.